1. Introduction
The Luxembourg direct tax authorities issued on 27 December 2016 new guidelines by means of the issuance of Circular L.I.R. no. 56/1 – 56bis/1 (hereinafter the “Circular”) which deals with the Luxembourg tax treatment applicable to Luxembourg companies engaged in intra-group financing transactions. The Circular details the application of the arm’s length principle to such transactions which principle has been codified in the Luxembourg direct tax law via articles 56 LIR and a newly introduced article 56bis LIR (which will apply as from 1 January 2017). Click here for an English translation of the Circular.
The Circular replaces two circulars issued by the Luxembourg direct tax authorities, i.e. circular L.I.R. no. 164/2 dated 28 January 2011 and L.I.R. no. 164/2bis dated 8 April 2011 (the “2011 Circulars”). Furthermore, the Circular states that it will start to apply immediately for any new requests made for an advance pricing agreement and that existing advance pricing agreements will no longer bind the Luxembourg tax authorities as from 1 January 2017 for taxable years after 2016. Such existing structures therefore may need to be revised in line with the Circular.
2. Background
Until the release of the Circular, Luxembourg-based intra-group financing companies were required to respect the conditions imposed in the 2011 Circulars when submitting a request for advance certainty as regards the transfer pricing used in respect of intra-group financing transactions. These 2011 Circulars imposed several substance and equity (at risk) requirements on such financing companies. It also contained, as a safe harbor rule, a minimum equity at risk equal to the lower of Euro 2 million or 1% of the amounts lent. The 2011 Circulars allowed the respective Luxembourg financing company to limit its equity at risk, e.g. via limited recourse clauses or group guarantees, so that its risk exposure would be limited and be in line with its equity position.
As from 1 January 2017, Luxembourg introduces a new article 56bis LIR which includes the basic and commonly used principles that a transfer pricing analysis should satisfy. These principles are claimed to be in line with the OECD Transfer Pricing Guidelines and reports on actions 8-10 of the OECD BEPS Project. However, it also provides for more detailed interpretative guidance on how to establish such transfer pricing analysis for Luxembourg tax purposes, where the OECD transfer pricing guidelines provides for a more ‘open standard’ on how to effectively apply the arm’s length principle – most notably in view of financial transactions, where currently detailed guidance is (still1) lacking in the OECD transfer pricing guidelines. The Circular serves to offer clarity as regards the interpretation by the Luxembourg tax authorities of the wording, meaning and scope of articles 56 and 56bis LIR as applicable to Luxembourg companies engaged in intra-group financing transactions.
3. The Circular
a. Definition of intra-group financing company
According to the Circular an intra-group financing company means any entity that carries out intra-group financing transactions, which comprises any activity consisting in the granting of interest-bearing loans or advances to related companies which are in turn financed by means of any financial instrument originated from within or outside the group.
b. Transfer pricing requirements / equity levels and equity at risk
The Circular stipulates that intra-group financing companies need to substantiate their remuneration on the basis of the OECD transfer pricing guidelines whereby the company is required to substantiate the level of such remuneration by means of a transfer pricing analysis documented in a transfer pricing report. Indeed, such analysis should be based on the outcome of a functional analysis which takes into account the functions it perform, the risks it assumes and the assets it uses in respect of the carrying out of the intra-group financing transactions. The transfer pricing analysis should also contain an economic analysis of market data extracted from comparable transactions.
In this respect the Circular clarifies the following points:
On a case by case basis, the appropriate amount of equity at risk should be determined. This level will ultimately depend on (the amount of) the assets used and the risks assumed. If the intra-group financing company is comparable with a regulated financial undertaking, it will be considered to have sufficient equity if it meets the solvability requirements as set out in EU regulation 575/2013 on prudential requirements for credit institutions and investment firms. What the 2011 Circulars considered a minimum required (the lower of Euro 2 million or 1%) no longer applies.
The appropriate amount of equity subsequently needs to be called upon when risks, assumed by the financing company, materialize. Any contractual arrangement or provision (e.g. limited recourse provision) purely aimed to minimize such risks are to be ignored for the purpose of determining the arm’s length remuneration.
c. Substance
As regards the minimum substance requirements imposed on intra-group financing companies, these are in line with those imposed in the 2011 Circulars and include the following:
The majority of the members of the board, directors or managers that have the power to bind the company need to be (professionally) resident in Luxembourg.
Key decisions as regards the management of the company have to be made in Luxembourg and at least one shareholder meeting per annum should be held in Luxembourg. A group finance company should have the decision-making capacity to enter into a commercial relationship that gives rises to financing risks and should have the capacity to take the decision to negotiate the related risks and should effectively exercise such decision-making functions. Where it outsources the daily activities of risk management, it must have the capacity to manage and monitor the outsourcing and, where needed, adapt or terminate such outsourcing.
The intra-group financing company must have the qualified personnel in order to be able to control the transactions. The company may however outsource some of elements of risk control provided such elements have no significant impact on the overall risk management.
The intra-group financing companies must not be considered a tax resident of any other country.
d. Safe harbor rules
The Circular provides for two safe harbor rules, one applicable to purely intermediary companies and one for companies having a similar profile to those of a regulated financial undertaking.
For intra-group financing companies that act as a pure intermediary financing company and that meet the above listed substance requirements, the Circular confirms that such companies will be considered to carry out at arm’s length transactions where they report an after-tax return in respect of their financing activities of 2% of the total amount of assets financed, as part of a “simplification measure” that requires the communication of its application (i.e. the taxpayer’s reliance on it) in the Luxembourg tax return, which in principle also triggers an exchange of information with other countries with which Luxembourg has concluded a tax treaty.
Furthermore, companies with a functional profile similar to that of a regulated financial undertaking may be considered to derive an arm’s length remuneration in respect of their financing and treasure functions if they derive an after-tax return on equity equal to 10%. The Circular states that the Luxembourg tax authorities will regularly review and where needed, update this percentage in order for it to remain in line with the relevant industry.
A taxpayer may choose to not apply these “safe harbors” based on appropriate (transfer pricing) justification. In case of deviating from the 2% safe harbor for pure intermediary financing companies, however, this would require a notification of such position to the Luxembourg tax administration in the tax return to be submitted, where it has already been noted in the Circular that this will only be accepted in exceptional cases. In case of deviating from the 10% safe harbor for group financing companies “similar to” regulated financial undertakings, further adjustments to increase comparability may be performed, but obviously will be closely monitored by the Luxembourg tax administration.
e. Request for Advance Pricing Agreement
A binding ruling on the transfer pricing aspects can be concluded with the Luxembourg tax authorities. If such request would be pursued, the Circular mentions a (rather extensive) list of minimum information and documents to be submitted, including a confirmation of the taxpayer that the information needed to assess the facts is complete and in line with reality.
4. Take away
The take away from all this is that Luxembourg-based intra-group financing companies have to review, reassess and, where needed, revise their current equity position, their equity at risk position, the level of their substance in Luxembourg in order to put these in line with the requirements imposed by the Circular, or to structure their intragroup financing transactions differently. Most notably the personnel condition imposed by the Circular may need specific attention. Taxpayers should also monitor further OECD BEPS work in view of transfer pricing guidance on financial transactions in due course of 2017.
Those taxpayers that wish to obtain (advance) certainty as regards their transfer pricing in respect of their intra-group financing transactions can file a request for an advance pricing agreement with the Luxembourg direct tax authorities. Like the 2011 Circulars, the Circular clearly states which information such request should, as a minimum, contain. Such information includes, inter alia, a detailed description of all intra-group financing transactions relating to the applicant and covered by the request, the qualifications of the relevant employees and a description of their duties, the mentioning of other countries affected by the financing transactions covered by the request etc.
In collaboration with Any Neuteleers (Tivalor)
